Dollar Rupee – Why RBI’s experiments with USDINR are not working?

Rupee weakness is nothing new. When there is geopolitical risk, oil prices are spiking, and FPIs are selling India; rupee weakness is inevitable. The bigger question is why are the RBI measures not having the desired effect?

Dollar selling – the easy way out

For a long time, the RBI used dollar selling as the sole method of propping up the rupee. The RBI would set a support level and if it did not work; then it would gradually keep moving the level higher. However, this strategy came at a cost. It resulted in depletion of forex reserves and that reduced the import cover that the Indian economy had. To reduce the impact of such dollar selling, the RBI also starting selling dollar futures in the forward market as well as in the offshore NDF market. However, dollar shorts also have a risk as they raise expectations in the markets of short positions being covered.

What has triggered weakness in the rupee

The Indian rupee has traditionally weakened around 3.0% to 3.5% each year against the dollar to adjust for the inflation differentials. However, several things have worked against the rupee in recent years. Since September 2024, FPIs have sold $63.6 billion in Indian equities, of which $32.8 billion of selling happened in 2026 itself. The second big factor is the rising bond yields in the US. While Indian bond yields are above 7%, US bond yields are also above 5%. A 2% spread is just not enough at a time when the rupee is depreciating by 3.5% each year. If yield spreads do not widen, FPI outflows will sustain and rupee will weaken. Of course, geopolitical risks in the Gulf are adding to the problem.

Why are the RBI measures not working?

The bigger question is why are the RBI measures not having the desired effect? For instance, the FCNR(B) deposits collected over $133 billion in a little over 2 months. However, nearly $90 billion out of that has been used to sell dollars and defend the rupee. At the same time, the net dollar short position remains inordinately high at $200 billion plus. If the dollar selling is not putting pressure on the reserves, the short dollar positions are raising expectations of short covering. Above all, there is the overhang of $133 billion of FCNR(B) deposits that have to be repaid in full over five years. The hedging of the principal amount itself entails a cost of $20 billion for the RBI over 5 years!

Rate hikes may be an unpalatable solution

One option that is yet to be explored is an aggressive rate hike by the RBI. Higher interest rates will widen the gap with US bond yields. For that, India will have to lead the hawkish path and not follow the Fed on rate hikes. A surge in rates will help to stem outflows and lead to rapid hardening of the Indian rupee. However, aggressive rate hikes will come at a high cost. It makes debt expensive and lowers equity valuations in the short run. The bigger concern for the government is that it can stifle GDP growth which has been robust. However, as inflation is curtailed, many of these problems will get addressed. Explaining that kind of a strategy to the markets will be a lot more complicated!